Introduction

Previously, we covered how Dividend Growth Investing fulfils all the requirements of an ideal income replacement strategy. This approach offers:

a safe and reliable income

a revenue stream that increases every year, offsets inflation and even increases your buying power

an approach allowing you to preserve your capital

an easily applicable method.

In this post, the formula for success will be revealed and explained. Its components will be covered individually. This will set the stage for future discussions on how to apply the method concretely.

The Formula for Success

When it comes to investing, our formula for success states:

High Quality Company + High Combination of [dividend yield and dividend growth rate] = Safe Increasing Income + High Total Return

Component 1: High Quality Company

Buy quality

The cornerstone of our DGI strategy is investing in high quality companies. By investing in those companies, we become business partners with their management team. As business partners, we benefit from the future success of these companies when some of their cash flow is distributed to us, shareholders, in form of a dividend.

The importance of choosing high quality businesses cannot be overstressed! In Finance (as it is also the case in many other spheres of life), the strong often gets stronger. Investing in the strongest companies is therefore a wise bet.

High quality, financially strong companies are better able to strive in all market conditions. During recessions, they have the financial means to buy struggling competitors that are selling at a discount. The high-quality companies thus emerge from recessions even stronger while their competitors either go bankrupt, are acquired or come out crippled. [1] [2]

When facing headwinds, companies with strong finances have more maneuverability and are better able to weather difficulties. They have a buffer that allows them to turn the ship if needs be, such as trying new strategies, developing new innovative products or acquiring other companies.

Examples of a high-quality companies overcoming headwinds abound. Let’s look at Microsoft Corporation (NASDAQ:MSFT), a company well-known for its operating system. This company was at the center of much negative news in 2013. To make a complex story short, its earnings had missed Wall Street’s estimates. In fact, its operating earnings had been decreasing since 2012. With the increasing popularity of smartphones and tablets, the market for personal computers was showing weakness. According to several newspapers and analysts, such change in consumers’ interest spelled doom for the company. [3] Microsoft attempted to compete with Apple’s iPad with its Surface RT, which proved to be a complete blunder. Similarly, it had not been able to make significant foray in the smartphone market. To add insult to injury, Google was becoming a serious competitor. It had recently come up with its Chromebook (released in 2011, [4]), its vision of the laptop. It was also offering for free its own version of office through its integrated online Google Apps.

Although Microsoft was facing several headwinds, it was still at the time an exceptionally high-quality company. It was one of the very rare companies boasting a AAA credit rating. It was still a cash printing machine with a very well covered dividend; the payout ratio was 34%. At the end of 2013, it had more than $77B in cash and short-term investments, which amply covered its ~$15B in short and long-term debts. [5] This financial flexibility gave ample leeway for the company to restructure and reinvent itself. Microsoft has been transitioning towards cloud-based software and services. Fast forward to 2017, this bet seems to be bearing fruit as its revenues have grown to $89B, from $77B in 2013. [6] Similarly, since 2013, its earnings per share have grown 25% (from $2.65 to $3.31) and its dividends an impressive 69.5% (from $0.92 to $1.56). This case exemplifies how investing in high-quality companies and being patient during difficult times can work out. And while you allow the management team to carry its turn-around plan, you collect your income in form of dividends.

In Bear markets, by definition the whole market falls at least 20% over at least a two-month period. [7] Although the stock price of high-quality companies will also stumble, that fall is often mitigated especially if these companies are part of more defensive sectors. This phenomenon occurs due to the flight-to-quality behavior of investors who shun riskier investments in favor of safer ones during more pessimistic times.

We can easily find examples of this flight-to-quality behavior by looking at the most recent bear market that occurred during the Great Recession. First, let’s look at the overall stock market. We will use the S&P 500 ETF (NYSEARCA: SPY) and the Vanguard Total Stock Market ETF (NYSEARCA: VTI) as proxies.

SPY went from a high of $158 in 2007 to a low of $67 in 2009 for a negative return of -57%. If dividends are considered, $4.9 were paid in those years, and the return was -54%. Even the dividend payout dropped 20% (from $2.72 to $2.18). [8]

VTI did even worse! It went from a high of $78.25 to a low of $27.76, giving a negative return of -62%. With dividends accounted for, that return was slightly better at 59%. The dividend payout sustained an important decrease between 2008 and 2009 of 43%! [8]

Let’s examine now one high-quality stock for each of the defensive sectors, namely Healthcare, Utilities and Consumer Staples and see if they fared better than the overall market.

Johnson & Johnson (NYSE:JNJ) is a Healthcare behemoth that has been sporting a AAA credit rating from S&P since 1987 [9] and that has been increasing its dividend yearly for 55 straight years. It went from a high of $72.7 to a low of $46.2, leading to a negative return of -36%. Not too shabby compared to the -62% of VTI! With dividends, that return climbed to -31%. Even better, the dividend payout increased 8% between 2008 and 2009. (from $1.79 to $1.93) [8].

Dominion Energy Inc. (NYSE:D) is a well-known utility with a BBB+ credit rating [9] that’s had been increasing its dividend for 14 years. Its return during the Great Recession was -45% when considering price alone ($49 to $27) and -38% when taking into account dividends. Similar to JNJ, its dividend payout increased 11% between 2008 and 2009.

For our final example, we will look at Costco, a multinational wholesale company with a credit rating of A+ and a dividend increase streak of 14 years. It sustained a -49% and -47% loss without and with dividends, respectively. Similar to JNJ and D, its dividend increased by 12% during that recession.

These examples clearly show how stock prices of high-quality, dividend growth, companies tend to fall less than the broader market during bear markets. In addition, if one was invested in a broad market ETF like SPY or VTI during that recession, one could rely neither on price nor on dividends as both decreased substantially! On the other hand, although prices of financially strong companies did drop, their decrease was much less than the overall market, and more importantly, their dividend payouts kept rising.

What is a high-quality DGI company?

To apply our Formula for Success, we need to clarify the characteristics of a high-quality stock. When we talk about quality in the world of stock investing, we are referring to the fundamentals of the underlying business that renders it particularly successful. Ultimately, the notion of quality is subjective. Nonetheless, one can examine several criteria, some quantitative and others more qualitative:

Financial strength:
Indicators of financial strength include increasing revenues, earnings and cash flow. Another very important indicator is creditworthiness, which reflects the ability of the company to service its debt.

Business model
The business model of strong companies exhibits certain characteristics. These companies offer products or services that are in demand and that surpass their competitors’. They show diversification of their customer base and of the geographic locations where they do business.

Economic moat
Economic moat refers to how difficult it would be for their competitors to replicate their business model and to steal market shares.

Corporate management/stewardship
When looking for high-quality companies, it is important to determine if the interests of the management team are aligned with the best interests of the company and of its shareholders. The following are some aspects of corporate stewardship that should be considered:

How well does management allocate capital?

Does management rely on excessive debt?

What is the vision of the leadership and has it showed proper execution?

What are the dividend and share buyback policies? Have they been respected so far?

Does management show exemplary integrity? Has management team stood by its words? Have there been any unusual accounting practices?

The second component of our Formula for Success is the combination of dividend yield and dividend growth rate. Both, the yield and the growth rate are important. They must be evaluated together, not individually.

Dividends are important to consider not only because they constitute the main income in the Dividend Growth Investing strategy, but also because they can be viewed as implicit signals from the management team about how the company is expected to do.

Dividends as Income

When looking at dividends from the income perspective, the ideal combination would be a high dividend yield coupled with a high dividend growth rate. This situation is more easily encountered during a bear market where the market as a whole has fallen, taking with it high-quality, dividend growing companies.

For example, Automatic Data Processing Inc. (NasdaqGS:ADP), a human resources management company boasting a AA credit rating [9] and a dividend growing streak of 43 years, saw its price drop to $28 in 2009 while paying a $1.32 dividend. ADP yield was 4.7%, almost 50% higher than the S&P 500 yield when the market reached bottom (SPY yield was 3.2%). Not only that, but ADP saw its dividend increase by 26% in 2008 and 13.7% in 2009.

In a bull market, high yield and high growth rate may be a combination more difficult to find, especially when companies are more richly valued. In that case, you must determine what your needs are. Do I need income today or do I need it several years down the road? Answering that question will determine if you go with a higher current yield and lower future dividend growth rate or vice versa. Nonetheless, it is still possible to find high-quality stocks trading in a sweet spot with current dividend yield higher than that of the broader market and a high single-digit/double-digit dividend growth rate.

Dividends as Signal

As important as the income they provide, dividends are also extremely useful for the information they imply regarding the financial health of the company and where management believes the business is heading.

Notion 1: The number of consecutive years dividends have increased is a major indicator of quality and of the strength of the company’s underlying business model.

Let’s stop and think about it.

A company must be darn strong to not only pay but increase its dividend every year for 15, 20 or more years despite all that can go wrong in the world. Dividends are not something virtual but real cash that the company must pay somehow. Some companies have managed to increase their dividends despite wars, recessions, natural disasters or other unfortunate events thanks to their phenomenal profitability.

Notion 2: By announcing a dividend increase, management signals that profits are expected to increase in the not-too distant future.

Since dividend cuts are viewed so negatively by investors, management teams usually try their best to avoid them. Company leaders showing good stewardship therefore do not announce a dividend increase if they believe their company cannot support it.

Conclusion

We have covered several important aspects of our Dividend Growth Investing approach.

I will state again the DGI Formula for Success:
High Quality Company + High Combination of [dividend yield and dividend growth rate] = Safe Increasing Income + High Total Return

Successful dividend growth investing relies on high-quality companies with a long history of yearly dividend increases.

The dividend yield and growth rate must be considered together. The optimal combination is a high current dividend yield and a high expected dividend growth rate.

Dividends are important as they are the fundamental income in DGI. Their growth rate can be viewed as an important signal from management regarding the expected profitability of the company.

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